Monday, September 3, 2012

My husband and I decided to buy a condo unit for use by my 2 college students. Instead of paying rent which is an outright "loss", we will be paying for a property which is "gain". We have enough cash in our emergency fund (which are in 5-yr tax free time deposits at 4-6%interest p.a.) to buy the condo unit in cash and earn the benefit of 12% discount. Or pay 45% downpayment without interest in 27 months and then pay the remaining 55% lump sum (thus avoiding bank financing) and still enjoy 3% discount.The dilemma is this: husband says we do the former--12% is way bigger than the 5-6 % the money will earn in the banks. But I choose the latter--at our age (43 and 45), we'll never know when we will have medical emergencies. I don't want to let go of our savings, we're still earning and we'll just pay for the condo unit on a monthly basis from the money we still have to earn.

The property costs 2.6M. If we withdraw from out time deposits, we get charged 10-50% of earnings depending on the bank, the number of years still remaining, plus documentary stamps costs.

What do you think?

Weng

Dear Weng,

From a purely economic standpoint, the reasoning of your husband makes sense since the additional 9% discount (12% vs. 3%) that your get by paying for the property with cash outright is greater than the 5 to 6% you earn from your time deposits. If you want a more systematic analysis, however, there are a couple of things that you can do: (1), determine how much more it would cost you in terms of interest per year to pay in installments, or (2) compare the present values of cash flows of both options.

The table above shows the different discounts applied to the two payment options (I assumed that the 3% discount for the installment option would be applied to the gross cost). Then, we see the payments that you would have to make under each option; to simplify matters, I just assumed that the balance for the installment plan would be due in 24 months instead of 27.

Obviously, the installment option would cost you more in peso terms, but how much more would it cost you per year in percentage terms, considering the time value of money? To do this, we first get the "incremental cash flows" of choosing the installment plan over cash payment, then compute for the internal rate of return (IRR) of the cash flows. Using the IRR function of Excel, we get 9.68% per year. This means that by choosing to pay in installments rather than cash, you will pay an implied interest or cost of 9.68% per year. And since this is higher than what you earn from your time deposits, you are better off choosing the cash payment option.

Or, taking the 5% from your time deposits as your "cost of money," you can just get the present value of the cash flows from the two options. Since paying cash has a lower present value of payments than the installment plan, then you should choose the former.

Of course, there are other non-economic and subjective factors that you might want to consider in choosing a payment plan. If paying the entire amount in cash would leave your emergency fund empty, you might be forced to resort to more expensive debt in case of emergencies. However, I assume that both you and your husband are still working and would have ample insurance coverage as part of your work compensation and are capable of saving a significant amount on a monthly basis to rebuild your emergency fund fairly quickly. So maybe you can afford to spend your entire savings this one time.

If you really want to be on the safe side, however, I propose this "middle-ground" solution: get a housing loan for 1 million with an interest rate of less than 9.68% (which I think you can get from Pag Ibig), use this and a portion of your savings to pay cash and avail of the 12% discount, and still have a 1 million peso emergency fund.